Financial Challenge – Day 5

NOTE: The entire challenge series is what I would do with my money and is merely my opinion. You should do thorough research and seek professional advice and decide to do what is best for you. My Disclaimer

Welcome to the second week of the Financial Challenge. While we spent some time last week looking how people with credit card debt should allocate the money that they will be saving, we also need to take a look at how those who are already ahead in the game and have extinguished their credit card debt should allocate the money that they’ll save. Once we have established where the money should be going, then we can get into the meat and potatos of getting your personal finances in order and reducing your costs to find that minimum of $100 a month we want save.

$100 dollars

I believe that saving money is by far the best investment that most people can make. My general guideline is that if you have less than $100,000 in liquid investments (no counting the value of your house here) then saving money with simple investment techniques (“simple investment techniques” means that you can place them in the investment and forget about them for 25 years) will get you a better return than trying to study the stock market and pick individual stocks. Once you reach the $100,000 level then you can decide how to proceed from there as you will have a solid financial foundation to work from to try and get a slightly better return.

Once out of debt, the first place to invest is your company’s 401(k) plan if they offer a matching bonus. In fact, you may actually want to make contributions to your 401(k) even while you have debt depending on what the company match is.

Many companies offer to match a percentage of money that you contribute to the company’s 401(k) plan. For example, if you put $1000 into your 401(k) plan, a company that matches 100% contributions would add another $1000 so that your 401(k) would receive a $2000 contribution. That’s a 100% return on your money just for putting it there instead of someplace else. Other companies may match 50% or 25% which mean they would add $500 or $250 to your $1000 contribution to the 401(k) plan. This is still an instant 50% or 25% return on your money. What percentage each matches (or if they even match at all) varies from company to company. Your goal is to invest as much money as you can into your company 401(k) plan as long as the company will match some percentage of what you invest. What we’re after here is the free match money.

I mentioned earlier that even if you had credit card debt, you might want to contribute to your company’s 401(k) plan instead of paying down the credit card debt. This is a difficult one that you will have to seriously consider. The money that you forgo in your company’s 401(k) match is money lost forever. On the other hand, if you place all your extra money into the 401(k) plan so that at some point you need to take it out of there early to pay off credit card debts, it makes little sense. Since this depends quite a bit on your individual circumstances, if this is an issue in your case, leave a comment with all your particulars to get a variety of opinions from those taking the challenge.

To sign up for your company’s 401(k) plan shouldn’t be difficult at all. Usually all you need to do is fill out some paperwork provided to you by your company and choose the percentage of your income you want deducted from each paycheck put toward the 401(k) plan (which, as we mentioned above, should be as much as you can up to the percentage that the company matches). Any money you put into the 401(k) is deducted from your pay before income tax withholding is calculated. Social Security taxes are taken out on the amount that you designate for your 401(k) plan and then standard taxes are deducted from the rest of your paycheck.

Another method that your company may use is an automatic enrollment feature. In this case, you are automatically placed into the company’s 401(k) plan for a specific percentage of your income without doing anything. If it’s not the correct percentage you want taken out, you must go to the personnel office and change it to the percentage that you want.

Once you are signed up for a designated percentage of your paycheck to be withdrawn into the 401(k) plan, you’ll need to decide what investment option to choose. When deciding, you must choose what’s appropriate for you and you bear the risk of your choice (not the company). While this may sound intimidating, the truth is that the choice is simple.

The choices that you will be given can range quite a bit from company to company with some only giving a few while others will give quite a bit. These are the choices you’re likely to see:

100% invested into a fixed account.
100% invested into a bond fund.
100% invested into a stock fund.
100% invested into shares of your company’s stock.
A combination of the above choices.

The investment you want to choose is the 100% stock fund. While this may sound risky to some of you (it does to many as over one-third choose a fixed account even though this is a poor choice), it really isn’t and this is why. Since you are receiving a match from the company (ie free money), even if the stock market dives terribly, your losses will be minimal to none. Over the long haul, you’ll end up way ahead.

stocks

Think of it this way. If your company matches 50% and the stock market has an absolutely miserable year and loses 30% of it’s value, you still didn’t lose any money. The only the money that is gone is the money that the company matched which was free. Even if you wanted to consider the worst case scenario where the stock market loses 99% of it’s value in one year, it still isn’t that bad. Why? Because if your 40 years old, you still have 25 years to contribute when the stock market is at it’s absolute lowest and can only go up (we’ll talk more about “dollar cost averaging” later). If you think about it this way, stocks are by far the best option.

Every good rule or strategy needs a good exception to go along with it and investing your 401(k) in stocks is no exception. The exception to this rule is if you are planning to withdraw the money from the 401(k) within a few years. Stocks perform well over long periods, but are quite volatile over short periods and that is why you should pick a safer investment when you are coming close to taking the money out.

There are also a couple of asterisks that go along with investing your 401(k) in stocks. If you currently are not in stocks and you have a sizable amount already saved, you don’t want to transfer it all into stocks. What you want to do is diversify that money placing 25% into each of the different choices. All future contributions, however, should go into the stock fund.

The second asterisk is that you should invest in a diversified stock fund. You don’t want to invest all of it in a single stock such as your company’s. Even if you company is doing very well or if you expect it will do well in the future. When it comes to long term investments, it’s never a good idea to put all your eggs in one basket.

The last issue with the 401(k) plan is the contribution limit. Again, since we are going after the matching funds, this usually isn’t an issue but it’s likely that your company’s plan will have a pre-set maximum percentage of income that you can place into your 401(k) from each paycheck. In addition, The government, not wanting to lose too much tax revenue, also places a maximum amount of money that you can place into a 401(k) on a yearly basis. In 2006, the annual dollar limit that an employee can defer to a 401(k) plan is $15,000.

In the time that you have set aside for the challenge today you should find out:

1) Does your company have a 401(k) plan
2) If it does, up to what percent does it match funds you contribute
3) Place all current funds in the 401(k) into a diversified portfolio with all future contributions going toward a diversified stock fund

Once you have set this up you can leave it alone until you are nearing retirement age and use your valuable time to concentrate on maximizing your savings.

For previous Financial Challenges

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18 Responses to Financial Challenge – Day 5

  1. Bill says:

    Great challenege – I can’t think of any circumstances where I would forego the company match on my 401(k), which is dollar-for-dollar up to 6%.

  2. EHadden says:

    Unfortuantely, I work for a public school district, which does not have a 401(k). We do, however, have a 403(b) program, but there is no match there. Until the wife and I manage to dig out of this hole that we are in, I will not be participating, although I know that I am missing out on some incredible compounding opportunities.

  3. ~Dawn says:

    I agree with Bill- I wouldn’t pass up free money. Ever!
    My company does the same match as his.

  4. Rob says:

    This is the best advice anyone could ever get.

    I started at age 23 contributing 6% with a 50% ER match. Four years later 8%. Six years later 10%. Now maxing it out.

    I just turned 36. If I never contribute another dime to this plan and get an 8% return I’ll have $1.2 million at age 65.

    All because I filled out one form at age 23.

  5. Frugal Momma says:

    Been already done with hubby’s 401k for several years. My goal by the end of the year is to be 15%. I don’t have a 401k but a Roth but I am maxing it out and it is diverisifed

  6. piannist says:

    Any advice on this would be appreciated: My husband contributes 5% to his 401k and there is no company match. We have several thousand in credit car debt/car loans, etc. I’m thinking we need to reduce the contribution to start paying some of this down, but he thinks we should keep the same contribution since it’s tax free. I just think we’re losing more in the long run. Also, if car loans are at the same rate as our higher interest credit cars (which still isn’t too high, but it’s something), wouldn’t we want to make paying those down a priority? Pay loans first? Reduce contribution? What do you think?

  7. pfadvice says:

    “Any advice on this would be appreciated: My husband contributes 5% to his 401k and there is no company match. We have several thousand in credit car debt/car loans, etc. I’m thinking we need to reduce the contribution to start paying some of this down, but he thinks we should keep the same contribution since it’s tax free. I just think we’re losing more in the long run. Also, if car loans are at the same rate as our higher interest credit cars (which still isn’t too high, but it’s something), wouldn’t we want to make paying those down a priority? Pay loans first? Reduce contribution? What do you think?”

    I have posted your question in the forums as you will likely get a lot more answers to it there (and varying opinions).

  8. Perky says:

    If there is no match, and we do have debt, we shouldn’t sign up right?

    What if the debt we have is only the house and car(3 or 4 months we should be there!)? should we sign up with no match or wait still?

  9. flash says:

    Perky has a good point. My first several jobs had great 401K matching and other retirement savings. My position with the might F500 had no match. The 401K is still critical to have, tax free money set aside and making money. For me, I spread over various accounts, stocks was only a partial investment, and have done very well. I don’t think all in stocks with no match is ideal unless you have access to some great funds in your program.

  10. pfadvice says:

    “If there is no match, and we do have debt, we shouldn’t sign up right? What if the debt we have is only the house and car(3 or 4 months we should be there!)? should we sign up with no match or wait still?”

    Getting ahead in the game 😉 Wait until tomorrow’s challenge – but the answer is “no” to begin with. There is a better investment than the 401(k) if your company doesn’t match the money.

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  12. Loi Tran says:

    I’d pay down the car loan first since you are not getting any company match. The returns you are going to get in your 401k are not guaranteed, but when when you pay down your debt, the savings from the interest payments are.

  13. Loi Tran says:

    As for investing in a portfolio, I’d put a small amount into a bond fund. Somewhere along the lines of 5%-20%. Bonds are not correlated to stocks and studies have shown that bonds may improve a portfolio’s risk adjusted returns. I’ve written a post about bonds in a portfolio. http://investingguide.blogspot.com/2006/01/bonds-in-portfolio-for-young-people.html

  14. Perky says:

    Thanks pfadvice :)

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  17. Floyd Grier says:

    What is the up side putting your money in a 401k plan with no company match

  18. pfadvice says:

    Not much. The main one would be convenience. If you woulddn’t be saving the money in some other way for retirement, then it could be positive.

    If you company offers an investment vehicle that is better than you can find elsewhere (doubtful) it could be better.

    And it could be better if the alternative investment where the money would go would not be tax deductible.

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